Government’s Rescue of AIG Fails to Calm Nervous Investors

September 17, 2008 at 6:20 PM EST

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The government's bailout of AIG failed to boost stock markets Wednesday, with the Dow dropping more than 400 points. Economic analysts examine the government's decision to aid the insurer and the state of financial woes.

GWEN IFILL: Now, the rationale behind the government’s decision and possible fallout yet to come. Ray Suarez picks up on that part of the story.

RAY SUAREZ: And for that, we get two views. Allan Meltzer is a professor of political economy and public policy at Carnegie Mellon University. He’s also a visiting scholar at the American Enterprise Institute.

And Michael Lewitt is president of Harch Capital Management, a money management firm.

And, Michael Lewitt, let’s start with you. AIG was teetering on the brink. The Federal Reserve stepped in. Was the right decision made to move in, in this way?

MICHAEL LEWITT, Harch Capital Management: It was the right decision. I think that, if AIG had failed, it would have caused catastrophic losses throughout the global financial system.

AIG is a uniquely global company. It has relationships with virtually every other financial institution in the world. And its failure, its inability to meet its obligations would have caused a cascade of troubles for other financial institutions. It would have caused potentially other hedge funds and other companies to fail.

And I don’t know if the losses could have been contained if the government had not stepped in.

RAY SUAREZ: Professor Meltzer, did the Fed do the right thing?

ALLAN MELTZER, Carnegie Mellon University: No. There were bids on the floor for AIG. AIG it didn’t take the bids. It thought it could get a better deal from the government. That’s a bad way to run the system.

We can’t afford to run a system and we won’t be able to where the bankers make the profits and the public takes the losses. That just is not viable.

Virtues and flaws of the bailout

Michael Lewitt

Harch Capital Management

We're all going to pay a price for this. The dollar is going to continue to deteriorate. The U.S. balance sheet is getting trashed. And this is no way to run a railroad, as they say.

RAY SUAREZ: But Michael Lewitt said there were very few choices because of the unique status of AIG in the world markets.

ALLAN MELTZER: AIG has four parts. One of them was in trouble. The other three make money. It could be sold. It should have been sold. It should have gone as a private company to some other private company. And that was an option that was available.

RAY SUAREZ: Michael Lewitt, were there other alternatives?

MICHAEL LEWITT: Not in the time period necessary -- you know, not in the time period they had. This was something that had to be done over a matter of days. You can't sell a company that quickly, in my view.

They did do it in the case of Merrill Lynch. I think Bank of America may find there are some surprises there. And in this case, the shareholders were wiped out, as they should have been.

So I think that no one got rich on this deal. And I think the right thing was done.

ALLAN MELTZER: It's not a matter of getting rich. It's a question of whether we're protecting the public interest or the private interest.

The government is here to protect the public interest. What it's doing is protecting private interests. And that's a big mistake and one that we shouldn't continue to tolerate.

We've gotten through now a whole range of these firms. The government has salvaged a number of them. That just puts all those losses onto the taxpayers. That's not where they belong.

RAY SUAREZ: Michael Lewitt?

MICHAEL LEWITT: Well, I don't disagree that the taxpayers are going to bear a heavy price for all of these rescues, but at the same time, had AIG not been rescued, the financial system, in my view, would have come apart.

And at that point, everybody, including the taxpayers, would have suffered grievous losses. As it is, in the wake of the AIG rescue, the financial system is barely functioning. Banks are not loaning to each other. Capital is unavailable.

And I think the reason for that is because people properly understand that AIG is going to cease to exist, that it's going to be liquidated, just in slow motion. And what the government was trying to do is prevent a free fall bankruptcy that would have just precipitated a continuing fall of dominos.

But there's no question Professor Meltzer is correct. The taxpayers are going to pay a price for this. We're all going to pay a price for this. The dollar is going to continue to deteriorate. The U.S. balance sheet is getting trashed. And this is no way to run a railroad, as they say.

ALLAN MELTZER: And it might have been better if we had allowed it to be sold. I've been following these problems for 40 or 50 years. You know, it always comes down at the end to this.

Someone goes to the secretary of the Treasury or, in this case, the chairman of the Fed and says, "If we don't do this, we're going to have a terrible depression. It'll be known as the Bernanke depression. And if you don't act, there's going to be a disaster."

Well, that's not always the case. And these disasters should be headed off early or should be left to the marketplace to settle. They made these mistakes, and they should pay for them.

The context of AIG's rescue

Allan Meltzer

Carnegie Mellon University

If there is a government problem, it's a problem to be handled by the Congress, not by the Fed.

RAY SUAREZ: Well, Professor, you said you've been following this for 40 or 50 years. Has the Fed ever come in, in this way, to buy an 80 percent stake of such a large company before?

ALLAN MELTZER: Not only that, but in 1921, way back in the midst of a terrible recession, depression, prices falling 20 percent a year, bigger than anything we've seen recently, the Congress came to the Fed and said, "You have to bail out the farmers."

The farmers were a big part of the economy at that time, and they had made bad purchases. The Fed said, "It's not our business," so Congress passed, created the Federal Land Banks.

A couple of years later, in the midst of the Depression, Congress came to the Fed and said, "We have problems with the housing industry." The housing industry often a place where there's problems. What did the Fed say? Said, "Not our problem." Congress created the Federal Home Loan Banks.

This is a problem -- if there is a government problem, it's a problem to be handled by the Congress, not by the Fed.

RAY SUAREZ: Michael Lewitt, was AIG a decent bet, given the fact that it had significant assets and many profitable operations?

MICHAEL LEWITT: Well, AIG, there's a great deal about AIG that is very attractive. The problem is the company was pushed to the brink and there was very little time to work out a solution.

The credit agencies, you know, decided to withdraw their ratings because the market had decided to withdraw its credit. And that became a problem that really literally had to be solved overnight, and that was unfortunate.

In the case of Lehman Brothers, the belief was -- and I think it was a correct one -- that the market had had at least six months to prepare for the problem and so they could let that company go.

There was no such luxury of time in the case of AIG. And I think the other thing is I think the AIG rescue needs to be viewed in the context of what's gone on before.

Frankly, you know, the rescue of Bear Stearns, you know, started a series of commitments on the part of the government that continued with the rescues of Fannie and Freddie and now with AIG.

If the government had not rescued AIG, the previous rescues really would have gone for naught. And these problems are all a culmination of years and years of bad policies and bad decisions.

And hopefully this will be an occasion for people at all levels of the system, all levels of the government to re-evaluate how we manage things, because we are in terribly serious trouble because of the results of decades of very bad thinking and very bad policies.

Weapons of 'financial destruction'

Michael Lewitt

Harch Capital Management

Everybody is greatly afraid of what will happen if a company as connected as Bear Stearns ... or a company even larger, like AIG, where there's no time to prepare for a bankruptcy goes bust or into a freefall bankruptcy.

RAY SUAREZ: Professor, what about Michael Lewitt's point, that given the amount of money that the federal government has already put on the line, the AIG bailout was necessary to make -- to save those previous investments?

ALLAN MELTZER: Well I'm not in favor of those previous investments, either. I agree with him that the government has been going into this and, as it goes into this, it encourages people to say, "Well, we're not going to take any of those deals from the marketplace because we might get a better deal from the government." And sometimes they do.

I would say we ought to look at Lehman Brothers. They let Lehman Brothers fail. Within a few days, just a few days, Barclays was there buying up some of Lehman's assets, the same thing.

AIG has a terrific insurance company all over the world. It has a premiere place in China, and it's doing very well there. It has a big aircraft leasing business. It does very well there. It has three major divisions that make money.

It's hard to believe that somebody wouldn't come in on a fire sale, just the way Bank of America came in on a fire sale of Merrill Lynch. It's just not true. It's just frightening.

And, you know, this has been a crisis where people on Wall Street were telling us in January, "This is like the Great Depression." Well, that was just an overstatement. It was a problem for them, a serious, major problem for them. But the rest of the economy is struggling along, doing pretty well, no depression.

RAY SUAREZ: Michael Lewitt, go ahead.

MICHAEL LEWITT: Well, I would just say this, that part of what Professor Meltzer I think is saying -- and I would agree with it -- is that the regulators are being held hostage to a degree by this, you know, what Warren Buffett once called weapons of mass financial destruction, which are derivatives.

One of the biggest fears with respect to the failure of Bear Stearns and with respect to the failure of AIG were the massive amount of credit default swaps that were on the books. And, you know, this is a market that's reportedly $62 trillion in face amount. There's no central clearing agency. No one knows who owes what to whom.

And the great fear is the great fear of the unknown. Nobody really knows, and everybody is greatly afraid of what will happen if a company as connected as Bear Stearns, where there's no time to prepare for a bankruptcy, or a company even larger, like AIG, where there's no time to prepare for a bankruptcy goes bust or into a freefall bankruptcy.

Lehman, people felt it was time to prepare and counterparties had six months to unwind their positions. In the case of AIG, there wasn't.

And I tend to be afraid of that very risk, because these credit default swap contracts are very complex, and nobody really knows what's going to happen when they unwind. The legal precedents are very uncertain. The contracts are not always drawn so precisely.

And so we're effectively held hostage by a market that regulators failed to regulate, that Wall Street, you know, really prevented from being regulated, made no steps to get regulated.

Risks to the bailout

Allan Meltzer

Carnegie Mellon University

Usually it's the Federal Reserve which is financing the Treasury. Now we have the Treasury financing the Federal Reserve.

MICHAEL LEWITT: And something needs to be -- you know, it's too late now, obviously, but now there's -- you know, everybody all of a sudden is a reformer. But, you know, a number of us have been calling for this problem to be fixed for a long time.

The SEC, a couple years ago, came out -- I believe it was the SEC -- and discovered that an enormous percentage of the trades in this market were not being closed on time. And so they quickly pushed the dealers into fixing that problem.

But, you know, this is just, you know, a ridiculous way to allow a market to grow that has this much influence on not just, you know, the United States' economy, on the global economy. And the fact that this happened is, you know, will probably go down in history as one of the most significant regulatory failures that we've ever seen.

RAY SUAREZ: Very briefly before we go, Professor, does the size of this intervention constrain the Fed from future action? If there's another AIG waiting in the wings, will it be unable to act because it's already got so much money on the line?

ALLAN MELTZER: Well, today, the Treasury came in to borrow money on a special issue for the Federal Reserve. Now, usually it's the Federal Reserve which is financing the Treasury. Now we have the Treasury financing the Federal Reserve.

Well, that doesn't mean -- that means they're not going to run out of money. They're not going to let them run out of money. And, indeed, the Federal Reserve can print money. So it's not going to run out of money. That's not where the risk is.

The risk is that, each time we do one of these bailouts, we encourage other people to take more risks and come for bailouts. So we end up with a system in which the bankers make the profits and the public takes the losses, in which the public interest is subverted to the private interest. And that's not a system that's going to survive.

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